Setting up for a Fall: Fantasy Pro Formas

WASHINGTON, DC-Much of the questioning of Boston Properties’ top management during the company’s recent quarterly earnings conference call consisted of the usual queries asked during these encounters. One back-and-forth with Douglas T. Linde, president, however, revealed an interesting glimpse into how complicated pinning down pro formas can be.

Basically, Boston Properties doesn’t think there’s going to be tremendous rent growth in Midtown Manhattan in the short-term, Linde said. “But that doesn’t mean there won’t be pockets of rent growth in particular submarkets,” he said. “In particular, the high-quality premier buildings in places like the Plaza District.”

Such a nuanced view, not surprisingly, makes acquiring properties tricky. Manhattan may be a top office market but memories of 2008’s long-gone valuations still haunt. The result is that Boston Properties, as well as other institutional investors, has found itself outbid on several properties in the city. Not that these other buyers are being misled by magical thinking, Linde added. “I don’t believe they are underwriting 30% or 40% rent growth over the next one to two years,” he said. “I assume what they’re doing is they’re underwriting 5% or 7% or 10%–little spikes here and there, and they’re getting to 40% or 50% rent growth over a seven to nine-year period of time–which, quite frankly, is probably not unrealistic.”

Clearly pro formas are not all or nothing for savvy commercial real estate investors: that is, 40% rent growth versus 2%. Still, this is one element of financial underwriting that is most prone to magical and fantastical thinking.

“Those numbers are not facts but expectations,” Mark Stapp, executive director of the Master of Real Estate Development program at the WP Carey School of Business at Arizona State University, tells GlobeSt.com. “I am afraid that the vast majority of underwriters overlook that subtlety. The fact is, one must always test or question the underlying facts behind those numbers.”

Memories of 2008, though, appear to be fading and increasingly lenders, from CMBS to smaller commercial banks, are making decisions about LTVs and debt service coverage ratios based on pro formas that–while not based on earlier premises of never-ending growth–paint a rosier recovery picture than may be warranted.

S&P noted the same in a recent report that looked at distributing trends in the CMBS market. “The part that we believe should be most alarming to investors is that the appraisals appear to be building in upside in rents and occupancy to arrive at a value for the properties in question instead of using in-place rents and tenancy at the time of closing,” wrote S&P credit analyst James Manzi.

Mistakes Stapp sees are along the lines of five-year balloon loans underwritten on the assumption that credit will be available when the loan matures and gross under calculating of expenses. Analyzing revenue potential is another, he adds.

“One mistake people make is to treat all tenants in an office building, say, as having the same risk profile,” he says. “The borrower then applies the same discount rate to everybody by discounting the net operating income.”

James M. Dockerty, executive vice president of Sabadell United Bank in Miami, is seeing similar signs of relaxed lending among some of his competitors. The smart banks, however, he says, are not open to doing anything that is based on pro forma projections. “We only lend money when the situation is real–when the cash flow is in place and proven.”

In addition, he tells GlobeSt.com, some banks such as Sabadell are more critical of the underlying tenants’ financial condition. “We are stress testing contractual rents. Each tenant lease is looked at very carefully to determine how reliable that tenant will be in making lease payments.”